[co-author: Caleb Strawn]
On August 23, the United States Securities and Exchange Commission (the “SEC,” or the “Commission”) adopted rules and rule amendments (the “PFA Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”) that impose new requirements on private funds and their investment advisers. Our prior blog posts on the PFA Rules offered a broad overview of the PFA Rules’ most important changes, summarized how the PFA Rules impact registered investment advisers’ quarterly reporting requirements, examined the PFA Rules’ effect on adviser-led secondaries and analyzed the PFA Rules’ new “Restricted Activities” Rule. This post addresses the PFA Rules’ prohibitions against and enhanced disclosure requirements regarding investor preferential treatment.
As explained in the adopting release, the SEC is concerned about the common private funds industry practice of granting preferential terms to some investors but not others (which is typically done via side letter). Although many preferential terms, like rights granted to meet an investor’s accounting, tax or regulatory needs, may have little to no impact on other investors, the SEC believes that other preferential terms, like preferential redemption rights or enhanced access to information, risk advisers placing their own interests ahead of their clients and subject investors, particularly smaller investors with less bargaining power, to potential deception and harm. To mitigate these risks, the SEC adopted Rule 211(h)(2)-(3) (the “Preferential Treatment Rule” or the “Rule”), which includes both (i) an outright prohibition on advisers granting preferential terms around redemptions and enhanced access to portfolio holding information and (ii) disclosure requirements for all other preferential terms. The Preferential Treatment Rule applies to all private fund advisers, regardless of whether they are registered with the Commission.
Prohibited Preferential Terms
Subject to certain exceptions, the Preferential Treatment Rule prohibits two categories of preferential terms: redemption rights and access to portfolio holding and exposure information. The Rule specifically targets these categories because the SEC believes that preferential treatment in these areas has a high risk of materially harming the other investors in a fund or investors in other similar pools of assets.
Preferential Redemption Rights. The Rule prohibits advisers from, directly or indirectly, providing investors in a private fund or in a similar pool of assets the right to redeem their interest(s) on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets. This prohibition is applied broadly, covering side letters as well as fund documents in which different share classes have different liquidity rights but are otherwise subject to the same terms.
In response to concerns that a complete prohibition would inhibit investors’ ability to obtain side letter provisions that they require by applicable law and that investors should have a choice of various liquidity options, the Rule includes two exceptions to the general prohibition. First, advisers may grant preferential redemption rights if an investor requires such right under applicable law, rule or regulation.1 Second, an adviser may grant an investor preferential redemption rights if the adviser provides the same redemption rights to all current and future investors, without qualification (i.e., the offering of preferential redemption rights to investors may not be commitment based).
Enhanced Access to Portfolio Holding Information. The Rule also prohibits advisers from, directly or indirectly, providing portfolio holdings or exposure information of a fund or of a similar pool of assets to any investor in the fund if the adviser reasonably expects that providing such information would have a material, negative effect on other investors in that fund or in a similar pool of assets. Similar to the prohibition on preferential redemption rights, the Rule includes an exception if the adviser offers the information to all other existing investors in the fund and any similar pool of assets at the same time or substantially the same time.
The SEC, noting its intent for the Rule to narrowly apply, acknowledged that there could be preferential access to portfolio holding or exposure information given to an investor in a closed-end fund that does not have a material, negative effect on other investors; and in this case, such preferential treatment would not violate the Rule. Whether the provision of such preferential information complies with the Rule is subject in each case to a facts-and-circumstances analysis.
Similar Pool of Assets. Both of the prohibitions outlined above apply to the other investors in the fund and investors in any similar pool of assets. The rule describes “similar pool of assets” as pooled investment funds with substantially similar investment policies, objectives or strategies. This comprehensive definition is intended to prevent advisers from structuring around the preferential treatment prohibitions. As with the determination of whether the provision of preferential information violates the Rule, assessment of what constitutes a “similar pool of assets” is a facts-and-circumstances analysis; however, the Rule provides that: (i) co-investment vehicles should be considered similar pools of assets and (ii) separately managed accounts are not similar pools of assets.
Disclosure of Preferential Terms
For all other preferential terms, including any preferential terms issued under one of the exceptions detailed above, the Rule requires written notice to both prospective and current investors of preferential terms provided by the adviser or any of its related persons, as soon as reasonably practicable.2
Prospective Investors. Advisers must provide each prospective investor with written disclosure of any preferential treatment related to any material economic terms that the adviser or its related persons have provided to other investors in the same private fund prior to such investor making an investment. “Material, economic” terms are those that prospective investors would find most important and that could significantly influence an investor’s bargaining position, including, without limitation, the cost of investing, liquidity rights, fee breaks and co-investment rights.
Current Investors. The Rule requires advisers to disclose all preferential terms to current investors, regardless of materiality or impact on other investors. The timing of such disclosure is based on the type of fund, as outlined below:
- Illiquid Funds. Advisers must provide preferential treatment disclosures to current investors as soon as reasonably practicable after the end of the fund’s fundraising period.
- Liquid Funds. Advisers must provide preferential treatment disclosures as soon as reasonably practicable after an investor’s investment in the fund is consummated.
The Rule also includes an ongoing disclosure requirement under which advisers must annually provide investors with disclosure of any preferential treatment given to other investors since the adviser’s last written notice.
Related Persons. It is also worth noting that the Rule applies to preferential treatment given by the adviser or its related persons. The definition of “related persons” includes an adviser’s officers, directors and partners; those under its control (or those in control of the adviser); and various other persons, such as non-clerical employees. Accordingly, the Rule will apply even when an adviser’s related person, and not the adviser itself, is a party to a side letter.
Form of Disclosure. For both prospective and current investors, an adviser’s disclosure of preferential terms must include enough detail to convey the preferential terms’ relevance. Advisers can meet this requirement by providing copies of the side letters themselves, or by offering a written summary of the preferential terms provided to investors, so long as the summary is sufficiently specific (especially around any preferential fee terms).
Application
As mentioned above, the Preferential Treatment Rule applies to all advisers, regardless of whether they are registered with the Commission. Advisers with $1.5 billion or more in private funds assets under management must comply with the Rule by September 14, 2024, and advisers with less than $1.5 billion in private funds assets under management must comply with the Rule by March 14, 2025. Any preferential terms granted to investors in existing funds closed prior to the applicable compliance date that would be prohibited under the Rule will have legacy status and continue to stand; however, all preferential treatment granted to investors in existing funds closed prior to the compliance date must be disclosed to investors by the compliance date in accordance with the Rule.
We expect compliance with the Rule — particularly the disclosure requirements for illiquid funds — to raise logistical challenges for advisers. The common practice of advisers granting certain investors “most favored nations” or “MFN” rights, which entitle them to opt in to more favorable terms negotiated by other investors with equal or lesser commitments, typically takes place in the months after a fund’s final closing. Now, the material, economic terms that would have been disclosed to investors during the MFN process will have to be disclosed during the negotiation process. Further, multiple investors may be negotiating preferential terms with the adviser up until the final hours before closing. The SEC has not yet provided specific guidance to advisers on whether and when making advance disclosures to prospective investors is required in the foregoing context. Increased disclosure under the Rule is intended to and will likely give investors (particularly small investors) stronger bargaining power and the benefit of preferential terms negotiated by larger investors; however, increased disclosure, as well as the logistical complexities and uncertainty around such disclosures, may also have a chilling effect on the negotiation of preferential terms between advisers and their investors.
_____________________________
1 The SEC considered whether this exception should also be available for formal investment policies or resolutions but ultimately determined that including such policies and resolutions in the exception would incentivize investors to adopt policies and resolutions intended to circumvent the rule. Thus, this exception is only available for redemption rights required by law, rule or regulation.
2 According to the release, whether the adviser has made preferential treatment disclosures “as soon as reasonably practicable” will also be a facts-and-circumstances analysis; however, the Commission believes that within four weeks of the investor’s investment, or the fund’s final closing, as applicable, is generally appropriate.
